How Markets Work · Pro · 5 min

Dark pools and high-frequency trading

You can explain what dark pools and high-frequency traders are, why they exist, and what they mean for a private trader's orders.

Market plumbing

Few terms in trading sound as sinister as dark pools and high-frequency trading. Hidden markets and robots trading in millionths of a second seem made for conspiracy stories.

In reality, both are parts of how modern stock markets work, with real advantages and real problems. Knowing what they are helps you separate useful information from noise, and see where the actual risks for a private trader lie.

Hidden quotes, machine speed

Dark pools. The term is not defined in US securities law. The SEC uses it for trading systems, usually alternative trading systems run by banks or brokers, that do not publicly display their quotes.

Their main purpose is large orders. A fund that wants to sell half a million shares on an exchange would show its hand, and other traders could move the price against it. In a dark pool, buyer and seller can be matched without that signal. Trades are still reported publicly, but the SEC noted in 2009 that these reports do not immediately identify the dark pool. Its concern: participants in a dark pool have information about possible trades that investors using public quotes do not.

High-frequency trading (HFT). In its 2010 review of market structure, the SEC noted that the term has no fixed definition and listed features often attributed to it:

very fast computer systems that generate, route and execute orders,
placing servers next to an exchange's systems, called co-location, to save time,
very short holding periods,
many orders that are cancelled soon after they are placed,
ending the trading day with little or no open position.

The SEC called HFT a dominant part of US equity trading, with estimates of typically more than half of the volume. Many high-speed firms act as market makers. That competition has helped make spreads in large stocks very tight. The criticism is that their quotes can vanish in a stressful moment, exactly when liquidity is needed most.

Big order, no signal

A pension fund wants to sell 500,000 shares of a large fictional company. On the exchange, the best bid shows only a few thousand shares.

Sent to the exchange in one piece, the order would walk deep through the book and signal its size to everyone.
In a dark pool, it can be matched with a buyer, often in blocks, at a price taken from the public market.
The trades appear in the public data afterwards, without showing in advance that a large seller was there.

For a private trader with 50 shares, this changes very little. The price you see is still the public price.

Common mistakes

"Dark pools are illegal." They are regulated trading systems that must report their trades.
"Robots steal from small traders." For small orders in large stocks, competition between fast firms has mostly meant tighter spreads.
"I can trade like a high-frequency firm." Their advantage is infrastructure measured in microseconds, not a strategy you can copy.
Ignoring fast markets. Quotes can disappear in seconds. Limit orders protect you better than market orders then.

The takeaway

Dark pools trade without showing quotes, mostly for large orders. High-frequency traders trade at machine speed. Neither replaces the public price.

Check yourself

Quick quiz

4 questions. Instant feedback, nothing is saved.

1Tap the step where the order is hidden from the public order book.

Tap the chart.

A dark pool does not display its quotes publicly. The trade only becomes visible when it is reported.
2Why do large investors use dark pools?

A large visible order can move the price against the investor before it is filled. Trades are still reported.
3Which is a typical feature of high-frequency trading, according to the SEC?

The SEC's 2010 concept release lists speed, co-location, short holding periods, frequent cancellations and ending the day close to flat.
4What does high-frequency trading usually mean for a small order in a large stock?

Many high-speed firms act as market makers. In calm markets they compete on price. In stress, their quotes can disappear quickly.

of 4 correct.